The advent of the Internet and electronic trading has completely changed how people invest in the stock market. While once the stock market was almost exclusively the domain of powerful businessmen with only a very small percentage of the public actually owning stock, today the stock market is part of everyday life for the vast majority of Americans. More people own equities, either directly or indirectly through mutual funds and pension funds, than at any time before.
In the first half of the twentieth century, a stockbroker was typically the intermediary between the investing public and the stock market. These brokers would “read the ticker tape” as it came out on long ribbons, and would then convey this information to their clientele at opportune moments. As technology has advanced, the ticker tape has been replaced by electronics, greatly enhancing the efficiency of price dissemination and lowering the learning curve needed to trade on the stock market.
With the advances in technology, the brokerage industry has also changed. Technological advances such as Electronic Communications Networks (ECNs) and the Small Order Execution System (SOES) and new and better access to research information have come together to empower the individual investor. The self-motivated investor does not need a brokerage firm to get research information, it is all available over the Internet. While once brokerages were almost exclusively full-service, offering investment advice and a multitude of financial services, today people have the choice of using discount brokers and online brokers to invest in the market. A discount broker offers access to the markets without all the advice a client typically gets from a full-service firm. As a result, those using a discount broker pay less to conduct transactions than a person doing business at a full-service firm does. Reduced trading commissions, sometimes more than 50% less than traditional full-service brokerage firms, are available to individual investors through discount brokers.
The automated systems associated with trading on the Web have reduced the broker's cost of executing trades, and therefore deep-discount online brokerages have been developed. These online brokers have enabled a large number of do-it-yourself investors to trade securities completely independent of financial advisors and stockbrokers. The Internet brokerage industry is currently executing more than 800,000 trades a day. The largest online brokerage firms have nearly 2 million accounts, and at least one stock trade in seven is executed over the Internet.
There are basically two types of people that participate in the stock market the—“investor” and the “trader”. The buy and hold investor has a long-term view of the market and buys securities with the intention of holding them through market ups and downs. The “institutional investor” makes investments and trades stocks on behalf of other people. Institutional investors buy and sell large quantities of stocks and may qualify for preferential treatment and lower commissions by trading large enough quantities. In the past, almost all trades made on the stock market were made through institutional investors. However thanks to the advent of discount and online brokerages, individuals who wish to invest in the market now have an abundance of information and electronic trading services available to them to make their own transactions.
A “trader”, as opposed to the buy-and-hold investor, is a person who buys and sells often, even intraday, with the objective of short-term profit. A trader looks for price swings and situations for profitable trading. Traders constantly monitor market moves, looking for trends, trend reversals, breakouts and all manner of stock movements.
Increasingly, individuals (“retail traders”) are speculating in different types of securities using online brokerages. Retail traders may be individuals who actively follow the financial markets, and like the excitement of speculating. Typically, these investors are young and have relatively high incomes, but have a lower net worth than traditional, full-service brokerage clients. They tend to trade frequently; at least a few times a week. A “day trader” is a retail trader who buys and sells stocks or options intraday, looking more for quick profits than long-term capital appreciation.
Several types of existing securities and trading methods are currently popular with retail traders speculating in the financial market, including financial futures contracts, exchange-based options, trading on margin and selling a stock short. Each of these types of traditional securities or trading methods has significant disadvantages to the retail trader.
A futures contract is an agreement from a buyer to accept delivery (or for a seller to make delivery) of a specific commodity, currency or financial instrument for a predetermined price by a designated date. Most futures contracts are bought on speculation about future prices, and most futures traders are speculators (i.e., they do not expect to take delivery of the product). Speculators intend to buy low and sell high. They make money by forecasting price movement. In the futures markets, speculators not only have to forecast price movement, but they also need to predict when a price will be higher or lower. This makes trading in futures more risky than trading in stocks. Owning a futures contract exposes the trader to theoretically unlimited risk if the position moves against him and he is unable to close it out due to market circumstances. In addition, many retail traders cannot invest in futures contracts because of the significant net worth required to trade futures.
An option is a trading instrument that represents the right to buy (call) or sell (put) a specified amount of underlying security at a predetermined fixed price within a specified time. The underlying security can be stock, indexes, bonds, currencies or futures contracts. The fixed price, or “strike price”, is the price at which the security underlying an option can be purchased (call) or sold (put).
The option purchaser pays a premium for the right, but not the obligation, to exercise the specifics of the option contract. An option is worthless upon expiration, and the premium paid for the option cannot be recouped. The option seller assumes a legal obligation to fulfill the specifics of the contract if the option is assigned to him or her, however the premium is the extent of the potential risk to the option buyer. It is a payment to the seller of the option to tie up the obligation on the security for the requisite time period—the longer the period, the higher the premium. Options lose value with time. This “time decay” is part of the premium paid for the option. Time value will decay, or disappear, as the option approaches the expiration date.
Options can be used in a variety of ways to profit from a rise or fall in the market. Buying an option offers limited risk and unlimited profit potential. Selling an option, however, comes with an obligation to complete the trade if the party buying the option chooses to exercise the option. Selling an option therefore presents the seller with limited profit potential and significant risk unless the position is hedged in some manner.
There are two types of options—calls and puts. A call option contract gives the holder the right, but not the obligation, to buy a specified amount of an underlying security at a specified price within a specified time in exchange for a premium. The call option buyer hopes the price of the underlying stock will rise by the call's expiration, while the call option seller hopes that the price of the underlying stock will decline or remain stable.
A put option contract gives the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time in exchange for a premium. The put option buyer hopes the price of the underlying stock will drop by a specific date, while the put option seller hopes the price of the underlying stock will rise or remain stable.
The strike price is the fixed price at which the security underlying an option can be purchased (call) or sold (put) at any time prior to the option's expiration date if the option is exercised. An option's expiration date designates the last day on which an option may be exercised. American-style options can be exercised at any time before the expiration day, while European-style options can be exercised only on the expiration date. Exchange traded options have an expiration month, and American-style options expire on the third Saturday of the expiration month.
An option's premium denotes the actual price a trader pays to buy an option or receives from selling an option. The “bid” is the highest price a prospective buyer is prepared to pay for a specified time and the “ask’ is the lowest price acceptable to a prospective seller. Together, the bid and ask prices constitute a quote and the difference between the two prices is the bid-ask spread.
Option pricing is a complex process. There are several major components that affect the premium of an option, including the current price of the underlying security, the type of option, the strike price as compared to current market price (the option's intrinsic value), the amount of time remaining until expiration (the option's time value) and the volatility of the underlying security.
In general, an option's premium is its intrinsic value plus its time value. “Intrinsic value” measures the amount by which the strike price of an option is in-the-money in relation to the current price of the underlying stock. A call option whose strike price is above the current market price of the underlying security has no intrinsic value. A put option whose strike price is below the current market price of the underlying security has no intrinsic value. The time value is simply the option value less the intrinsic value. As the option approaches expiration, the time value goes to zero. At expiration the only value in an option, if any, is its intrinsic value.
The time value portion of the option premium depends on volatility. “Volatility” is a percentage that measures the amount by which an underlying security is expected to fluctuate in a given period of time. Basically, it is the speed of change in a market. Options often increase in price when there is a rise in volatility even if the price of the underlying security doesn't change. Options of a high-volatility stock generally command a higher premium because they have a greater chance of making a big move and being in-the-money by expiration.
Historical volatility measures a stock's propensity for movement based on the stock's past price action during a specific time period. Implied volatility is a computed value that measures an option's volatility, rather than that of the underlying security. The fair value of an option is frequently calculated by entering the historical volatility of the underlying security into an option-pricing model, such as the Black-Scholes for stocks. The computed fair value may differ from the actual market price of the option. Implied volatility is the volatility needed to achieve the option's actual market price. For example, if the market price of an option rises without a change in the price of the underlying security, implied volatility will have risen.
Exchange-traded options are not efficient for a retail trader for a number of reasons. First, exchange-traded options tend to have a wide bid/ask spread. The market maker or specialist at the exchange prices a significant markup into the two-way quote he offers to the market. This spread, which covers his hedging costs and profit, can make short-term options trading costly and generally inefficient. Traditional exchange-traded options have significant levels of time value and implied volatility, the movement of which can cost a speculator returns even if he is right on the movement of the underlying index or stock. This can make options trading extremely expensive for traders speculating on relatively small moves in the market. For example, the transaction costs on a representative at-the-money call on the S&P 500, including commissions and bid/ask spread, may be close to 15% of the premium, while the minimum trade size may average approximately $1500 per contract. The implied volatility of an option fluctuates, which can cost the trader potential gains even if the market moves in the predicted direction. In addition, the minimum trade size may be an obstacle for many retail traders.
Over-the-counter options and contracts have the same types of limitations as do exchange-traded options, and are additionally limited to institutional investors in blocks typically of $1 million or more. Therefore, they are also inadequate for retail traders to speculate in the market.
Retail traders may also speculate by buying on the margin. Buying stocks on margin is limited by Federal Reserve regulations. In addition, the risk of a margin call makes this type of trading risky. Short selling stocks is also risky, and requires substantial margin.
Meanwhile, new regulations at the Securities and Exchange Commission (SEC) have spawned the development of the Alternative Trading System (ATS)—an ATS is a new method of trading financial instruments (stocks, bonds, currencies, option, etc.) on an electronic platform that directly connects buyers and sellers. Trades on an ATS bypass exchanges and dealer networks. The development of Alternative Trading Systems has led to greater parity between institutional and retail investors. However, these systems are still limited to traditional securities.
In view of the foregoing, it can be appreciated that a substantial need exists for a financial instrument that provides for speculating in the market with a small minimum trade size, no required net worth and limited risk, while still providing high leverage capabilities. In addition, a need exists for a trading system designed to trade such a new financial instrument.